Research Papers: Strategic Defaults on 2nds, and MBS "Skin in the Game"

A couple of new research papers ...

• From Julapa Jagtiani and William W. Lang at the Philly Fed: Strategic Default on First and Second Lien Mortgages During the Financial Crisis

The researchers look at the data and notice that a large percentage of borrowers who are in default on their first mortgage and still making payments on their 2nd. They ask "Why might households default on their first mortgage but not default on their home equity loans?"

They offer several explanations, and conclude:

Our results overall suggest that people default strategically as their home value falls below the mortgage value; they exercise the put option to default on their first mortgage. However, they tend to keep their HELOCs current in order to maintain the credit line available to them, particularly for those who have already used their credit card lines.

Another possible explanation that the authors didn't explore is that the 2nd is recourse, and the borrower has sufficient other assets and believes the 2nd lender will pursue them.

• From Christopher M. James as the SF Fed: Mortgage-Backed Securities: How Important Is “Skin in the Game”?

This economic letter explores the importance of lenders having "skin in the game". The recent financial regulation require securitizers to retain at least 5% of the credit risk for residential MBS. The author looks at several deals where the originator had some risk (through affiliated deals) and concludes:

Overall, these results suggest significant performance differences based on the loss exposure of the mortgage originator. In short, skin in the game matters for performance. More important, because in this study the residual interest retained by the sponsor is 3% or less of the total value of the securitization, these findings suggest that a 5% loss exposure requirement is likely to have a significant impact on loss rates.

This appears to support the "skin in the game" requirement.